Money Supply

The money multiplier is the reciprocal of the reserve ratio. Under the assumption that banks do not hold excess reserves, the reserve ratio will be equal to the reserve requirement set by the Federal Reserve. For a reserve requirement of 5%, the reserve ratio is 1/20, and the multiplier is, therefore, 20. When the multiplier is 20, a banking system with $500 in reserves can support   in demand deposits.

If the reserve requirement rises from 5% to 10%, the reserve ratio rises from 1/20 to 1/10, and the multiplier falls from 20 to 10. At the higher reserve requirement, the banking system's $500 in reserves supports    in demand deposits.

For a given level of reserves, a higher reserve requirement is associated with a smaller money supply. At the higher reserve requirement, banks must hold a larger fraction of their deposits as reserves. This keeps more reserves away from the money creation process (it keeps new loans from being made, which would lead to more deposits, which would lead to more loans, and so on). Therefore, the higher the reserve requirement, the fewer the demand deposits generated in the money creation process from a given change in reserves.

To increase the money supply, the Fed must buy government bonds. In order to pay for the bonds, the Fed creates money. Its purchase of bonds puts the new money in the hands of the public. Assuming that households do not hold cash, the new money will be placed in demand deposits with banks.

At a reserve requirement of 10%, the money multiplier is 10. Therefore, the money supply will grow by 10 times the initial increase in demand deposits from the Fed's open-market purchase. If the Fed buys $20 worth of government bonds, demand deposits and bank reserves will rise by $20. The $20 increase in reserves will support an increase in the money supply of    as banks lend out the excess reserves generated by the Fed's purchase.

Uncertain economic conditions cause banks to hold some excess reserves, increasing the...